New Federal Tax and Securities Rules
Affecting Municipal Finance

By JEANETTE CORLETT, Illinois Development Finance Authority
and
GRACE ALLISON, Katten Muchin & Zavis

Financing municipal projects just became a little easier, thanks to the lobbying efforts of municipal officials nationwide. Title VII of the federal Revenue Reconciliation Act of 1989 (the "1989 Tax Act"), signed into law by President Bush on December 19, 1989, provides issuers with partial relief from restrictions first imposed by the federal Tax Reform Act of 1986 (the "1986 Tax Act"). At the same time, new regulations adopted by the Securities and Exchange Commission (SEC) and effective January 1, 1990 give municipalities more responsibility in the disclosure process, requiring issuers to take a more active role.

During the late 1980s, municipal officials found it increasingly difficult to fund their infrastructure and economic development projects with tax-exempt municipal bonds due to tax law changes. Although the Congressional intent was to prevent perceived "abuses" in the bond market, the new provisions generally made the task of borrowing unduly complicated. Recent changes restore some flexibility to the debt financing process for certain types of governmental projects, while imposing new limits on issuers of insurance reserve bonds and other types of tax-exempt debt. In summary, the new legislative and regulatory provisions which impact municipal debt financing are:

• the extension of provisions that permit tax-exempt financing for both manufacturing projects (commonly known as industrial revenue bonds) and single-family mortgages (also known as qualified mortgage bonds);

• changes in the requirements relating to arbitrage rebate;

• restriction of the issuance of so-called "hedge bonds," a provision which limits the ability of local officials to invest self-insurance funds financed with municipal debt; and

• new regulations relating to the process of disclosing information about the issuer at the time the securities are issued.

Industrial Revenue Bond Financing ($10M exception for small issues)

Many municipal officials are unaware that manufacturing projects can still be financed with tax-exempt bonds. Although the 1986 Tax Act generally limited the use of "small issue" industrial revenue bond proceeds to the financing of manufacturing facilities, it also extended the sunset date for this provision from December 31, 1986 to December 31, 1989. In addition, the 1986 Tax Act includes special rules which allow the current refunding of certain outstanding "small issue" industrial revenue bonds issued before 1987, even if the refunded bonds did not finance a manufacturing project. Thus, since the passage of the 1986 Tax Act, the Illinois Development Finance Authority has been able to fund 47 manufacturing projects through the issuance of more than $150,000,000 in tax-exempt industrial revenue bonds.

Under the 1989 Tax Act, the provision which permits industrial revenue bond financing of manufacturing facilities has been extended through September 30, 1990. The provisions allowing current refundings do not sunset and remain unchanged.

Qualified Mortgage Bonds.

Like the industrial development bond provisions, the provisions authorizing the issuance of mortgage revenue bonds or mortgage credit certificates for owner-occupied residences were due to expire on December 31, 1989. The 1989 Act keeps these provisions alive until September 30, 1990.

Arbitrage Reporting and Rebate

For many municipal issuers, the 1986 Tax Act's biggest impact was in the area of arbitrage rebate, generally considered to be among the most confusing and controversial of federal tax law provisions affecting tax-exempt bonds. In the municipal market, arbitrage is the practice of borrowing at lower, tax-exempt rates of interest and investing at higher, taxable rates of interest, creating an additional source of municipal revenues. The 1986 Tax Act required municipalities to track investment income earned on tax-exempt bond proceeds and to rebate to the federal government amounts earned in excess of the yield on the bonds. This provision generally affected all issuers of municipal debt that were not able to spend 100% of their bond proceeds within a six month period. The promulgation by the Treasury last year of 243 pages of arbitrage rebate regulations left no doubt that rebate computations would be time-consuming and expensive. For example, according to an article appearing in the July 25, 1989 issue of the Bond Buyer, Rhode Island planned to spend almost $30,000 in 1989 to monitor and perform

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rebate calculations for three multi-purpose general obligation bond issues, roughly triple the amount of rebatable arbitrage profit earned on those issues.

Successful lobbying by the public and private sector has produced a new rebate "safe harbor" in the 1989 Tax Act. These new provisions are NOT retroactive and are effective only for bonds issued after December 19, 1989. In essence, the 1989 Tax Act retains the six month provision for all issuers of municipal debt, but exempts a new category of bonds from arbitrage rebate. Significantly, bonds issued to finance private, for-profit projects, such as manufacturing facilities or residential rental projects owned by private developers, are not eligible for the 24-month safe harbor.

To qualify for the new rebate safe harbor, at least 75% of the net proceeds of the bonds must be used for a construction project owned by a governmental unit or a 501(c)(3) organization. In addition, at least 10% of "net proceeds" must be spent within six months, at least 45% within one year, at least 75% within eighteen months and 100% within two years of issuance of the bonds. The term "net proceeds" is defined to include not only proceeds from the sale of the bonds but also investment earnings on those proceeds. Special rules apply if there is a "reserve fund" involved in the financing, as is common in revenue bond financings in Illinois, e.g., sewer or water bonds. The new two year safe harbor is further complicated by the availability of four irrevocable elections, each of which can have significant economic consequences and may be made only on or before the date of issuance. Bottom line: although potentially useful, the two year safe harbor is a complex rule which can only be relied upon after a rigorous and careful analysis of the facts at hand.

Limitations on "Hedge" Bonds

Many issuers are concerned about the effect of the new "hedge bond" rules on insurance reserve bonds. Under the 1989 Tax Act, a bond is a "hedge bond" if either (a) the issuer does not expect to spend 85% of its proceeds within three years of issuance or (b) more than 50% of its proceeds are invested at a guaranteed yield for four years or more. "Hedge bonds" are generally taxable unless stringent expenditure requirements are met, e.g., 85% of all spendable proceeds must be spent within five years of issuance.

Importantly, the hedge bond rules do not apply if 95% of the net proceeds of the issue are invested in tax-exempt bonds not subject to the alternative minimum tax. For potential issuers of insurance reserve bonds, the most likely practical effect of the hedge bond provisions is to force the investment of insurance reserve bond proceeds in tax-exempt non-AMT bonds. A transitional rule exempts a municipality from the non-AMT tax-exempt bond investment requirement if it has taken official action on the financing before September 15, 1989 and can complete the financing no later than July 1, 1990.

New SEC Disclosure Requirements

As of January 1, 1990, underwriters in municipal financings are subject to the disclosure requirements of the new Securities and Exchange Commission Rule 15c12-12 (the "Rule"). The rule was adopted by the SEC following its investigation into the default of the Washington Public Power Supply System bonds and its subsequent report to Congress. The rule specifies procedures for underwriters to provide information to the investment community and applies to financings of $1,000,000 or more.

While the rule does not directly change the content of the disclosure information provided in the prospectus or official statement, the issuer will be required to make certain representations to the underwriter (which is most likely to be in the legal document known as the bond purchase agreement). •

Recent visitors this past month . . .

U.S. Senator Paul Simon	Comptroller Roland Burris

February 1990 / Illinois Municipal Review / Page 7